An unintended consequence of the TARP-and-switch

While Justin has had his eye on Hank Paulson, I’ve been listening to the House hearing on how well investors, servicers and lenders are going along with mortgage modifications.

Barney Frank had nice things to say about the efforts of Frannie, JP Morgan Chase and Bank of America (never mind that B of A got sued into changing the terms of its Countrywide loans), but then he took servicers to task for not more aggressively modifying mortgages held in securitizations.

Of course, there’s a fundamental problem with modifying those loans: for each securitization trust, there can easily be hundreds of bondholders with legal rights, and good luck coordinating all of their interests and wishes.

As Frank pointed out, Treasury’s original plan to buy toxic assets off bank balance sheets would have made the U.S. government the sole owner of many of these securitized trusts. And once the feds owned the paper, they could have done whatever they wanted, including telling servicers to cut interest rates or reduce principal balances across the board. Well, Frank didn’t go into that level of detail, but that’s the logical extension.

Now, because of the TARP-and-switch, we’re still talking about how we can get investors and the servicers of their investments to eagerly adopt loan modifications. Frank talked about having to “restructure the servicing mechanism,” but it wasn’t clear to me if that would be retroactive or going forward. He seemed pretty serious about it, though, saying, “You should not have a legal form where the authority to make important decisions is so spread out that no one can make them.” (I know someone who would agree.)

One option that doesn’t seem to be on the table is TARP-and-switch Part II. As Justin reported, Paulson said this morning that, for now, buying illiquid assets “is not the most effective way to use TARP funds.”